Elite Chinese Politics and Political Economy

My name is Victor Shih, currently an assistant professor of political science at Northwestern University specializing in Chinese politics. This blog shares my musing and discussions on Chinese politics and political economy with interested readers. You can contact me at vshih AT northwestern.edu, and my website, where I post my recent research is: http://faculty.wcas.northwestern.edu/~vsh853/

Wednesday, January 07, 2004

Hi All, I have been away for a while, but the fun is back. Beijing has decided to bail out Construction Bank and Bank of China with a 45 billion USD injection from its foreign exchange reserve (see article below). But the implications are not clear. See my comment to Chinapol below.

From the NYT article and from two UBS reports I read, it seems that the forex injection is structured differently than you have described. Essentially, SAFE has placed 45 billion worth of dollars or US treasury into Huijin, which in turn invested it in CCB and BOC in exchange for CCB and BOC shares. The primary purpose of this exercise is to recapitalize the two banks. According to Basel rules, core capital of banks must consist of owner’s equity in the form of highly liquid assets, like cash and US bonds. I suspect this money will primarily not be used to reduce NPL ratio. Using US dollars to reduce NPL would have an expansionary effect on Chinese money supply. Another exercise will have to be used to reduce NPL ratio, particularly in CCB, since it is scheduled to be listed next year. The exercise which you described, the bond switch, seems more appropriate for reducing NPL ratio.

The question I have for the group is precisely where the money in the foreign exchange reserve comes from. Related, is there any direct connection between the foreign exchange reserve and the government budget? (besides investor confidence).

HONG KONG, Jan. 6 - China announced a complex transfer on Tuesday of $45 billion from its soaring foreign exchange reserves to two of the four big government-owned banks, the third large bailout in the banking system in less than six years.

The transaction is intended to help shore up the financial institutions, the Bank of China and the China Construction Bank, so they can sell stock for the first time, the Chinese central bank said in a statement. The central bank admonished the commercial banks to do a better job of controlling fraud and limiting bad loans.

"When dealing with bad assets, they have to strictly investigate the responsibility of the related officials," the statement said. "They have to fight fiercely against those who have tried to run away from bank loans through illegal behavior."

Beijing bars Chinese journalists from reporting on the full extent of the banks' troubles, especially writers for mass-media publications read by many depositors. But with their promises of tough action against errant bank officers, the statements issued on Tuesday by the central bank and other agencies hinted at a concern about public perceptions of the bailout.

The costs of the American savings and loan bailout more than a decade ago - $123.8 billion in public funds and $29.1 billion in supplemental deposit insurance premiums from financial institutions - drew considerable complaints from politicians and the public in the United States. China has been eager to prevent a similar controversy. Its latest bailout, while costly, covers less than half of the nonperforming loans at two of the four troubled banks, and in an economy that is one-eighth the size of America's.

Tao Dong, an economist at Credit Suisse First Boston, said that "$45 billion is probably not sufficient, but a very decent number to start with." Mr. Tao said that while the latest bailout, split equally between the two banks, showed the government's interest in cleaning up the industry, what Chinese banks really need is to reform their lending practices so they stop making more bad loans. "Most important is having new credit-risk management established,'' he said. "Without that, any new money will be lost."

The need for another bailout underlines the problems that have vexed China's financial system even through two decades of rapid economic growth. The big four banks - the others are the Industrial and Commercial Bank of China and the Agricultural Bank of China - say that 20 percent of their loans are nonperforming. But Western analysts say that up to 45 percent of borrowers do not repay loans, although this share may be falling. By contrast, in the third quarter, loans at American commercial banks insured by the Federal Deposit Insurance Corporation that were more than 90 days past due or were nonperforming represented 1.24 percent of all outstanding loans.

Bankers said the Chinese banks' best chance of selling stock would be to list their shares on Western markets as quickly as possible - to take advantage of the mania lately with investors asking few questions and Chinese initial public offerings oversubscribed as much as 700 to 1.

"Why do you want to buy Chinese banks?'' a Beijing banker asked. "What makes you think these guys will do anything any differently in the next four years?"

China doubled the capital base of the four big banks in August 1998, by effectively giving them $32.5 billion through two complex swap agreements. In 2000 and 2001, it set up four asset management companies that bought $169 billion worth of nonperforming loans from the four banks at face value. The asset managers, owned by the finance ministry and indirectly by the central bank, have been struggling ever since to sell these loans for pennies on the dollar.

After each of those bailout actions, further loan losses quickly eroded the banks' capital bases.

Provincial and municipal governments put pressure on local bank branches to approve loans to politically connected individuals and to money-losing government-owned enterprises that employ large numbers of people. The four big banks are trying to address this problem by centralizing in Beijing their decisions on loans and by installing computer systems to monitor lending patterns.

The State Administration of Foreign Exchange said in a statement that it was transferring the money for the latest bailout to a new, specially created management concern, the Central Huijin Investment Company, which will then invest the money in the banks. The company's directors and supervisors will come from the foreign exchange administration, the finance ministry and the central bank, giving these agencies a continuing role in the two banks' ownership and financial management even after they sell stock.

Beijing's use of foreign exchange reserves caught the attention of currency traders, who have been looking for any sign that officials might allow the Chinese yuan to appreciate in value, as demanded by American, European and Japanese officials.

But a financial expert who insisted on anonymity said the two big banks were required to keep the money in dollars, which would make it easier for the central bank to continue preventing traders from bidding up the value of the yuan.

The central bank has been printing yuan on a vast scale to buy dollars and prevent its appreciation. It has then taken some of the extra yuan out of the financial system by selling bonds and withdrawing from circulation the money used to pay for them.

Enough yuan have nonetheless been issued to allow banks to lend more money in the first seven months of 2003 than in all of 2002. This has prompted fears that the banks may have engaged in another round of reckless lending that will produce a fresh wave of defaults.

The central bank now keeps the yuan in a tight range around 8.28 to the dollar. The financial expert said government officials had promised the two banks that they could exchange the dollars for yuan later if necessary at a rate of 8 to the dollar. This would act as a hedge against losses if the yuan does appreciate. It could also suggest an acknowledgement by Beijing of an eventual appreciation of the yuan.

Ryan Tsang, director for greater China financial services ratings at Standard & Poor's, said the accounting rules would let the banks count dollars as capital for purposes of meeting international capital requirements, without converting them to yuan.

Desmond Supple, an economist at Barclays Capital, wrote in a research report on Tuesday that the banks would be able to write off loans as uncollectible and make corresponding accounting entries against their equity without converting the dollars into yuan.

The State Administration of Foreign Exchange said the transfer to the banks was actually accomplished at the end of last year, which will allow the banks to show the extra capital in their year-end accounts. Several bankers said this might make it easier for the banks to pursue stock offerings by the end of this year. The foreign exchange agency said that even after deducting $45 billion, China's foreign reserves leaped $116.84 billion last year, to $403.25 billion.

Standard & Poor's and Moody's each welcomed the latest bailout as a sign that Beijing was addressing difficult problems in the banking industry instead of letting them pile up. "It's a very good development,'' Yen Wei, a vice president at Moody's, said. "It really demonstrates the government's commitment."